632598256894

This theory is far from perfect, as disparities can exist for years. In part these are due to government
policy about taxes, business and capital regulation, and the ease of moving money across international
borders.
Just as major moves in the stock market are difficult or impossible to predict, exchange rates can
vary dramatically and unexpectedly.
Theory: Purchasing Power Parity
Purchasing power parity tells us that, in general, things should cost the same in one country as they do
in another.
When it is cheaper to buy durable goods or services in one country, there will be an incentive for
businesses to shop for bargains there. People will tend to stop the purchase of local goods and services
and instead look to that other country. At times, there can be an incentive to smuggle. Someone from
the European Union may find that good-quality jeans sell for much less in the United States than they
do in the major cities of Europe. If you need jeans and your business brings you to Indianapolis, you
may purchase the jeans there. When you return to your home country, you are required to declare your
purchases, and often this generates a duty or value-added tax.
The Economist magazine publishes the “Big Mac” index a couple of times each year. This table
shows the price of a McDonald‟s Big Mac in a number of currencies and what those prices become
when translated into U.S. dollars. The spread is quite large. There is a tendency for the prices to move
toward each other, though, and it is just one indication of what may happen to future exchange rates.
Still, the disparities have lasted many years.
Even within one country, the prices of goods and services will not be the same everywhere. For
comparable quality, retail stores will reflect price differences based on local costs and taxes. Examples
include the purchase of cigarettes in New York City versus an outlet in North Carolina, or the
purchase of a flat panel TV at an upscale full-service retailer in San Francisco compared to a Wal-
Mart in Venice, Florida.
One effect of the Internet is to allow consumers everywhere to compare prices and shop for
bargains.
Dad: Rodney, if you decide to take a vacation in Europe, China, India, or any other country, it would
be worth checking the Big Mac index to see how far your dollar will go. As you know by now, the
exchange rates can vary enough that there have been good years for your vacation and bad years.
Futures and Options